THE SEC V. UNLICENSED BROKER/DEALERS: THE GOOD, THE BAD, AND THE UGLY by William H. Caffee White Summers Caffee & James, LLP I. What activity requires registration as a broker under the Securities Exchange Act of 1934 (the Exchange Act )? Under Section 15(a)(1) of the Exchange Act, it is unlawful for any broker or dealer to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security unless such broker or dealer is registered with the SEC. II. Who is a broker? A broker is defined in Section 3(a)(4)(A) of the Exchange Act as any person engaged in the business of effecting transactions in securities for the account of others. III. Who is a dealer? A dealer is defined in Section 3(a)(5)(A) as any person engaged in the business of buying and selling securities for his own account. IV. Broker or finder? Is a broker involved in effecting transactions in securities or merely introducing parties who then complete the transaction on their own? A. FINDERS 1) According to the SEC, transaction based compensation is a one factor test for the requirement to register as a broker. 2) Some type of compensation for introductions has generally been permitted since Paul Anka, SEC No-Action Letter (July 24, 1991). 3) Important factors identified by the SEC: a) Paul Anka had a bona fide, pre-existing business or personal relationship with these prospective investors; b) he reasonably believed those investors to be accredited; c) he would not advertise, endorse or solicit investors; d) he would have no personal contact with prospective investors; e) only officers and directors of the Senators would contact the potential investors; Page 1
f) compensation paid to the Senators officers and directors would comply with 1934 Act Rule 3a4-1; g) he would not provide financing for any investors; h) he would not advise on valuation; i) he would not perform due diligence on the Senators' offering; and j) he had never been a broker-dealer or registered representative of a broker-dealer. 4) Although no single factor has been dispositive in SEC no-action letters over the years, factors given weight by the staff include: a) whether the finder was involved in negotiations; b) whether the finder engaged in solicitation of investors; c) whether the finder discussed details of the nature of the securities or made recommendations to the prospective buyer or seller; d) whether the finder was compensated on a transaction-related basis; and e) whether the finder was previously involved in the sale of securities and/or was disciplined for prior securities activities. This factor was not included as dispositive of finder status in the Kramer and Maiden Lane cases cited below. 5) SEC v. Kramer, 778 F. Supp. 2d 1320 (M.D. Fla. 2011) rejected the SEC s view that the existence of the one factor transaction based compensation test. Factors in Kramer indicating a finder may be a broker and registration is required are: a) works as an employee of the issuer; b) receives a commission rather than a salary; c) sells or earlier sold the securities of another issuer; d) participates in negotiations between the issuer and an investor; e) provides either advice or a valuation as to the merit of an investment; and f) actively (rather than passively) finds investors. 6) The SEC suggested these factors that the court decided against using: a) received transaction-based compensation; b) actively solicited investors (by distributing promotional material and directing people to the issuer's website); c) advised investors about the issuer (by telling people that the issuer was a good company and suggesting that people read its press releases); d) used a network of associates to promote the issuer; e) demonstrated a regularity of participation (through the money that Kramer earned and the two-years over which the conduct occurred); f) promoted the shares of other issuers, and g) earned commissions rather than a salary as a Skyway employee. Page 2
7) The court in Kramer found Kramer was a finder (and not a broker) because he did not: a) become involved in the negotiations of any securities transactions; b) discuss the details of the transaction; c) analyze the financial status of the related public company; and d) promote the investment to any brokers directly. 8) Maiden Lane Partners, LLC v. Perseus Realty Partners, G.P. II, LLC, 2011 WL 2342734 (Mass. Super. May 31, 2011) also rejects the SEC s presumption that receipt of transaction based compensation renders the recipient a broker. The court in Maiden Lane, while reaching the same result as Kramer, identified specific elements that would evidence broker behavior: a) negotiation of price or any of the other terms; b) involvement in key points of the transaction such as analyzing the issuer s financial needs; c) discussing details of the transaction; and d) recommending the investment. 9) Merely bringing together parties to such a transaction did trigger the need for registration as a broker. 10) Law Firms as Finders A Virginia law firm tried to obtain No Action Letter in 2010 for receiving transaction-based compensation when referring its corporate clients to potential investors. Brumberg, Mackey & Wall, P.L.C. The SEC rejected Brumberg s request for a No Action Letter and said that, any person receiving transaction-based compensation in connection with another person s purchase or sale of securities typically must register as a broker-dealer or be an associated person of a registered broker-dealer. The SEC then concluded that Brumberg s proposed arrangement would give Brumberg a salesman s stake in the transactions creating a heightened incentive for Brumberg to engage in sales which necessitate broker-dealer registration. B. BUSINESS BROKERS 1) If they only get fees in asset sales, no need to register. 2) If they participate in stock sales, they need to register. 3) The SEC granted no-action relief to Country Business Inc. SEC No- Action Letter (Nov. 8, 2006) because CBI would only have a limited role Page 3
in negotiations and would not have power to bind parties in the transaction. 4) Would not engage in any transaction in securities. 5) Would receive a fixed fee. 6) Would not assist purchasers with obtaining financing other than providing uncompensated introductions to third-party lenders. 7) Business brokers have their apologists. In a letter to SEC Chairman Mary Schapiro, from Tabb, Inc. (Texas Association of Business Brokers) (Oct. 19, 2009) arguing that the cost of registration for main street business brokers who deal in small business sale transactions would be prohibitive and exceeds any public benefit. V. Consequences to Brokers and Issuers if Broker Needed a License A. TO THE BROKER 1) Regulatory Problems. Cease and Desist Orders, injunctions, civil penalties by both SEC and state securities commissions, denial of future applications to register as a broker and possible criminal referral. 2) Economic Loss. Inability to receive the benefit of their bargain with the issuer as Section 29(b) of the Exchange Act provides that: Every contract made in violation of this title or any rule or regulation thereunder, and every contract...the performance of which involves the violation of, any provision of [the Exchange Act] or any rule or regulation thereunder shall be void: (1) as regards the rights of any persons who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract. This section suggests that in civil litigation, an unregistered agent acting on behalf of the issuer will be compelled to return their commission, fees and expenses; and that the issuer may justifiably refuse to pay commissions, fees and expenses at closing or recoup them at a later time. A maximum three year or one year from the date of discovery statute of limitation applies. Page 4
B. TO THE ISSUER Put Right for Purchasers. A purchaser may bring an action to rescind a purchase of securities solely because the broker needed a license and did not hold one. Mills v. Electric Auto- Lite Co.8 says Section 29(b) implies a private right of action and that [t]he interests of the victim are sufficiently protected by giving him the right to rescind.... The plaintiff must demonstrate a direct relationship between the violation at issue and the performance of the contract; that is, the violation must be inseparable from the performance of the contract rather than collateral or tangential to the contract. Berkeley Inv. Group, 455 F.3d 195; GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 201 (3d Cir. 2001). If an agreement cannot be performed without violating the securities laws, that agreement is subject to rescission under Section 29(b). Berkeley Inv. Group, 455 F.3d 195. Note that the existence of relationships between issuers and finders should be disclosed to investors in offering documents together with the risk that the consequences contemplated by Section 29(b) of the Exchange Act may come to fruition. C. TO REGISTERED BROKERS 1) FINRA Troubles. Splitting commissions with unlicensed broker is prohibited by FINRA Rule 5110(f)(2)(L). 2) Liability for Aiding and Abetting Unregistered Brokers. Registered Broker-Dealers are liable for aiding and abetting operations of unregistered broker-dealers. Exchange Act 20(e) provides that any person that knowingly provides substantial assistance to another person in violation of a provision of the Exchange Act, or of any rule or regulation issued thereunder, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided. VI. State Securities Law Issues A. CONDITIONS ON EXEMPTIONS 1) Conditions on Exemptions. Section 402 (b) (9) of the Uniform Securities Act provides that an exemption for a limited offering is permitted if no commission or other remuneration is paid for the offer or sale of securities other than to a registered broker-dealer. Page 5
2) Washington conditions its equivalent of SEC Rule 505 on no commissions or other remuneration is paid to non-washington licensed brokers. 3) ORS 59.035(12)(a) conditioned on no commissions or other remuneration being paid to anyone (licensed or not). B. GENERAL SOLITICIATION ISSUES There are SEC No Action Letters permitting registered brokers to use their relationships with customers which can serve as the basis for establishing a preexisting relationship with those investors. These letters obviously do not extend to unregistered brokers. C. CIVIL LIABILITY An issuer who engages unregistered broker-dealers can face private actions for rescission from investors as some states have provided a private right of rescission for innocent parties who buy securities through unregistered brokers. California, in fact, provides for rescission, attorneys fees and treble damages. CAL. CORP. CODE 25501.5 (2009); CONN. GEN. STAT. 36b-29 (2008); FLA. STAT. 517.211 (2009); 815 ILCS 5/13 (2009); Tex. Sec. Act 33; N.J.S.A. 49:3-71(a)(2); Bramblewood Investors, Ltd. v. C&G Assocs., 262 N.J. Super. 96, 619 A.2d 1332 (June 26, 1992); Carrousel N., Inc. v. Chelsea Moore Co., 9 Ohio App. 3d 344, 460 N.E.2d 316 (1983); Brandenburg v. Miley Petroleum Exploration Co., 16 F.2d 933 (N.D.S.D. 926). Page 6